Restaurant First Watch: Q2, traffic problems likely temporary (FWRG)

First Watch Restaurant Group, Inc. (NASDAQ:FWRG) reported the company’s Q2 results in early August, showing a sizeable decline in traffic amid weaker consumer traffic. First Watch also updated the company’s guidance for 2024, now reflecting weaker H2 traffic as well as on the background of the disputed consumption expenses. Despite the slower traffic, First Watch’s overall growth story continues to progress well, unless weaker traffic becomes a long-term trend even after consumer spending recovers in the industry.

In my previous article on stock, “Restaurant First Watch: Slowing traffic doesn’t disrupt growth story“, we remained at a Hold rating on the stock as the weakness in the Q1 report appeared to be priced in amid First Watch’s growing growth story. As traffic weakness persisted, First Watch shares have now lost -31% of their value compared to The S&P 500’s 8% return after the article was published on May 9, the stock now represents a more attractive opportunity.

Q2 Report: Solid Earnings Growth Despite Slow Traffic

First Watch’s Q2 results showed financials in line with Wall Street expectations – revenue of $258.6 million, up 19.5% from a year earlier, thanks to a 10.1% increase in sales system-wide and First Watch’s previous franchise restaurant acquisitions, exceeded the Wall Street consensus. with a small margin of $0.9 million. Same-restaurant sales were expectedly weak at -0.3%, driven by a weak -4.0% drop in traffic as First Watch maintained higher prices that compromised diners. Same-restaurant sales performance of -0.3% in the quarter was clearly linked in the Q2 earnings call to industry-wide weakness, as weak sales were seen in the restaurant industry amid weak consumer spending. First Watch also reports that consumer weakness mainly affected weekday breakfast and daytime lunch restaurant chains, boding poorly for the company. First Watch’s low price flexibility, which aims to drive healthier long-term traffic instead of maintaining short-term traffic at the cost of margins, significantly contributed to the -4.0% traffic decline in Q2.

Compared to some industry peers, sales weakness is also understandable. Dine Brands ( DIN ) saw same-restaurant sales decline -1.8% in Applebee’s and -1.4% decline in IHOP in Q2, Denny’s ( DENN ) showed a comparable decline of -0.6 %, and Cheesecake Factory (CAKE) showed a comparable -1.4% decline, also highlighting a weak consumer – I don’t think First Watch’s Q2 traffic weakness is likely a sign of the company’s demand fundamentals deteriorating.

Adjusted second-quarter EPS of $0.18 also beat the Wall Street consensus by a beat of $0.04 as First Watch prices rise amid weaker consumer demand and lower cost inflation rose gross margins by 1.0 percentage points to 21.9%. Overall, higher sales also contributed to an increase in total operating income of $5.1 million to $16.5 million at a margin of 6.4% despite weak traffic, a solid earnings performance in my opinion, when we consider the weakness of the industry.

The guidance of the first watch has been changed again

While First Watch’s financials came in pretty good in Q2 given the industry context, the change in guidance from 2024 was more negative as First Watch now expects the weakness to continue through the half of second. First Watch now expects comparable sales to decline -2% to 0% in 2024, compared to 0% to 2% growth expected after the Q1 report, quite a turnaround. In my view, the turnaround is still justified by weaker consumer spending, highlighted by weak Q2 peer sales, as well as persistently low consumer sentiment. As such, I don’t think delayed 2024 comparable growth is likely to play a big role in First Watch’s long-term growth story.

Despite a lower comparable growth expectation, First Watch’s total revenue growth range was maintained at 17-19% and adjusted EBITDA range at $106-112 million – the 51-57 planned net restaurant openings in 2024 maintain a good pace in overall financial performance despite a lower organic traffic outlook.

Updated Valuation: FWRG shares are now attractive

I updated my discounted cash flow (DCF) model for First Watch stock to determine an approximate fair value. I now forecast revenues to grow at a total CAGR of 11.8% from 2023 to 2033 and a steady 3.0% growth thereafter, down slightly from my previous 2023-2033 CAGR estimate as the weak outlook in the short term requires some caution.

I have also adjusted my margin estimates slightly – while I still expect the First Watch restaurant expansion to be a positive contributor to overall margin expansion as it represented in the second quarter, we now estimate the eventual EBIT margin level more conservative at 6.0% from 7.0% previously.

Given that First Watch is guiding for high capex of $125-135 million in 2024, I’ve revised my cash flow conversion estimate down slightly over the next few years amid more aggressive restaurant expansion. However, the company should eventually generate very healthy cash flows as growth slows.

Updated financial estimates put First Watch’s estimated fair value at $21.38, 42% above the share price at the time of writing – after the stock has now fallen very significantly due to near-term weakness likely caused by weak industry spending, I think the stock makes a pretty attractive investment case in a basic scenario.

The fair value estimate is up from $19.73 previously due to a lower WACC used.

CAPM

A weighted average cost of capital of 8.00% is used in the DCF model, down from 9.57% previously. The WACC used is derived from a capital asset pricing model:

In Q2, First Watch had interest expense of about $3.4 million, which makes the company’s interest rate 6.94% with the current amount of interest-bearing debt. As First Watch has had to increasingly finance the company’s growth through debt, we estimate a long-term debt-to-equity ratio of 20% instead of the previous 10%.

To estimate the cost of equity, I use the 10-year bond yield of 3.66% as the risk-free rate. The equity risk premium of 4.11% is Professor Aswath Damodaran’s estimate for the US, updated in July. We kept the beta estimate at 1.07. With a liquidity premium of 0.5%, the cost of equity is 8.56% and the WACC at 8.00%.

Considerable risks still exist

While I now see stocks as a good risk-reward investment, the risks still exist. For example, the company has now had to take on more debt to finance the restaurant expansion, with $194.8 million of interest-bearing debt on First Watch’s balance sheet after Q2. Higher debt brings more investment for shareholders, acting as a notable risk.

Weak industry sales are also a considerable risk, as shown by the performance of First Watch stock in previous months. While I think traffic drops are likely only temporary, longer-term or persistent drops could easily damage the investment case.

Take away

Shares of First Watch have fallen dramatically in recent months as the company’s traffic outlook has weakened. Q2 results and revised 2024 guidance highlight traffic weakness, but I still think First Watch’s pricing strategy and expansion should lead to good long-term earnings growth, especially as profitability increased even in Q2 from scale increasing and prices maintained. As the share price now represents a good risk-reward in my view, I am upgrading my rating on First Watch Restaurant Group to Buy.